GDP Shrinks 0.1% on Government Cuts, but Consumer, Business Spending Offer Hope

The U.S. economy shrank for the first time in more than three years in the fourth quarter, underscoring the halting nature of the recovery. But the strength of consumer spending and business investment suggested that the economy will grow, albeit slowly, this year.

Gross domestic product—the broadest measure of goods and services churned out by the economy—fell at a 0.1% annual rate in the fourth quarter of 2012, according to the government's initial estimate out Wednesday.

The details weren't as discouraging as the headline. The drop, a surprise, was driven by a sharp fall in government spending and by businesses putting fewer goods on warehouse shelves, as well as by a decline in exports. The mainstays of the domestic private economy—housing, consumer spending and business investment in equipment and software—were stronger.

Asian markets opened down after news that the U.S. economy has shrunk for the first time in three years. The WSJ's Mark Cranfield explains the impact on Asian markets.

Real Time Economics

A one quarter contraction of economic output doesn't mean the economy is formally in recession, but it is unusual for such contractions to happen in the middle of economic expansions. In fact, it has only happened one time in the past fifty years.Read more.

Research firm Capital Economics called the report "the best-looking contraction in U.S. GDP you'll ever see." Forecasters didn't see the decline as a harbinger of recession. They predicted the U.S. will expand at around a 2% pace in the current quarter, though the mood could shift Friday when the government releases its monthly snapshot of the job market.

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Investors pushed down stock prices but didn't seem overly worried either. The Dow Jones Industrial Average, which has been climbing steadily in past weeks, fell 44 points, to close at 13910.42.

In their statement after Wednesday's meeting, Fed policy makers said it appears that "growth in economic activity paused in recent months, in large part because of weather-related disruptions and other transitory factors." The Fed said it still saw downside risks to the economy, even though it expected a return to moderate growth in the months ahead.

The U.S. joined other advanced economies in reporting contractions in the final months of last year. The U.K., Germany, Spain and Belgium have said their economies shrank in the fourth quarter, and several more euro-zone members in coming weeks are expected to report their own declines. Budget cuts appear to be a leading factor driving the contractions in many of those nations.

Deficit cutting in advanced economies is an important reason why global growth is expected to barely improve this year. The International Monetary Fund last week projected global growth of just 3.5% this year, a slight pickup from the estimated 3.2% growth in 2012, due partly to budget tightening in the U.S. and Europe. The International Monetary Fund expects advanced economies to expand just 1.4% this year, compared with 5.5% growth among developing economies.

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Wednesday's GDP report portrayed an economy stuck in low gear. For 2012, the economy grew 2.2%, up from the 1.8% growth of 2011, but still below the roughly 3% pace notched during healthier times.

For now, the economy is riding largely on the backs of consumers. Consumer spending, adjusted for inflation, increased at a 2.2% rate in the fourth quarter, up from 1.6% in the third. That included a jump in spending on durable goods, which are big-ticket items such as cars and refrigerators.

One thing that is helping consumers: They are starting to see substantial income gains after years of stagnation. The GDP report showed after-tax income rose at a rate of 6.8%, adjusted for inflation, the fastest pace since the recession.

One company benefiting from stronger consumer spending is Nando's Peri-Peri USA, a closely held chain of chicken restaurants in the Washington, D.C., area. Same-store sales rose roughly 5% in the final months of 2012 compared with a year ago, said Chief Executive Burton Heiss.

Economist John Mauldin joins Markets Hub with an outlook on the U.S. economy, and his take on the Federal Reserve's effect on the stock market. Photo: Getty Images.

Mr. Heiss said he believes consumers are feeling more secure as housing and other parts of the economy improve. Higher home prices, for example, might be giving consumers the confidence to spend more freely on going out. Mr. Heiss added that the strength seems to be continuing: Sales have picked up slightly since the start of the year.

U.S. companies stepped up investment in equipment and software during the quarter, with business investment rising at a rate of 8.4%, the strongest pace in a year. That defied expectations that companies would pull back due to worries over the "fiscal cliff" budget dispute in Washington.

The slower inventory investment was the biggest factor behind the contraction. Businesses essentially sold items from warehouse shelves, rather than placing new orders with manufacturers.

That may have been due to inventory accumulating too quickly last summer and some businesses becoming extra cautious about restocking. The upside is that with inventory levels now depleted, many businesses will be forced to replenish, possibly boosting growth in the current quarter.

Meanwhile, government spending, which has been a drag on growth for more than two years, declined for the ninth time in 10 quarters. The biggest cuts came in military spending, which tumbled at a rate of 22.2%, the largest drop since 1972. But state and local spending also fell, dashing hopes of stabilization after a rare increase in the third quarter.

Military analysts said the decline likely was a result of pressure on the Pentagon from a number of areas.

Among them: reductions in spending on the war in Afghanistan as it winds down, a downturn in planned military spending, a constraint placed on the Pentagon budget because the federal government is operating on short-term resolutions that limit spending growth, as well as concern that further cuts may be in the pipeline.

Pentagon officials already have imposed tighter controls on military spending to deal with the challenges.

David Berteau, a former Defense Department official who now heads the International Security Program at the Center for Strategic and International Studies in Washington, said he was surprised by the sharp drop and predicted that persistent uncertainty about the defense budget would continue to be a drag on the national economy.

"Is this a blip in the data or is it a trend?" he said. "I think you're seeing a trend."

The effect of defense cuts on the economy in the fourth quarter likely raises the stakes of looming budget fights between the White House and congressional Republicans. The White House said the GDP report showed the need for Congress to avoid "self-inflicted wounds" and reach a deal.

Companies tied to the defense industry already are bracing for cuts.

Noel McCormick, president of McCormick Stevenson, a small engineering firm in Clearwater, Fla., that designs weapons for major defense contractors, said big clients have told him they may resort to layoffs and cut spending if cuts happen.

That would have a "tremendous" impact on McCormick's 12-person company, he said, likely causing it to cut back as well.

"There is a great deal of angst associated in the coming months," Mr. McCormick said.

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